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A Strategic Perspective on Compensation

Management
George T. Milkovich
Cornell University

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A Strategic Perspective on Compensation Management
Abstract
[Excerpt] The notion that compensation policies are strategic, thereby affecting the missions of the
organization, has considerable currency. This is part of the current popularity of all things strategic. While
some may write it off as another fad, a less cynical view is that a strategic perspective on compensation is part
of a growing recognition that macro-organizational issues are an important part of the study of human
resource management (Dyer, 1985).

Keywords
CAHRS, ILR, center, human resource, compensation, organization, management, compensation policies,
economists, policy, practices

Disciplines
Human Resources Management

Comments
Suggested Citation
Milkovich, G. T. (1987). A stragtegic perspective on compensation management (CAHRS Working Paper
#87-01). Ithaca, NY: Cornell University, School of Industrial and Labor Relations, Center for Advanced
Human Resource Studies.
http://digitalcommons.ilr.cornell.edu/cahrswp/444

This article is available at DigitalCommons@ILR: https://digitalcommons.ilr.cornell.edu/cahrswp/444

 A STRATEGIC PERSPECTIVE

ON COMPENSATION MANAGEMENT1

George T. Milkovich

Working Paper 87-01

Center for Advanced Human Resource Studies

ILR School

Cornell University

This paper has not undergone formal review or approval of the

faculty of the ILR School. It is intended to make the results
of Center research, conferences, and projects available to others
interested in human resource management in preliminary form to
encourage discussion and suggestions.

To appear in the 1988 volume of Research in Human Resources

Management, editors Ken Rowland and Gerald Ferris, JAI Press.
Portions of this paper were presented at the Academy of
Management, 47th Annual Meetings, New Orleans, 1987.
 2

INTRODUCTION

The notion that compensation policies are strategic, thereby affecting

the missions of the organization, has considerable currency. This is part

of the current popularity of all things strategic. While some may write

it off as another fad, a less cynical view is that a strategic perspective

on compensation is part of a growing recognition that macro-organizational

issues are an important part of the study of human resource management

(Dyer, 1985).

The importance of a strategic perspective on compensation rests on

three fundamental tenets. The first is that compensation policies and

practices differ widely across organizations and across employee groups

within organizations. To some students of organizations this may be self

evident. But to others, such as economists using human capital models to

examine compensation differentials, differences in organizations'

compensation policies and practices are treated as random noise with little

relevance. Anecdotal evidence and sporadic surveys of specific policies

or practices report that differences do exist. (The Conference Board,

1984; American Productivity Center, 1987). For example, some organizations

claim to position their base pay to meet the market, while others follow

it; some design incentive schemes to emphasize long-term performance, others

short term. Some firms employ individual based incentives while others

emphasize group or team based gainsharing schemes. Some decentralize the

administration of compensation, others do not. Some disclose very specific

information about pay to employees, such as ranges and merit guide charts,

while others communicate only the broad policies, such as fairness and

competitiveness. Surprisingly little systematic evidence exists on the

 3

effects of these differences. So the proposition that policy and practice

differences have meaningful effects requires more systematic study.

The second tenet is that the decisions managers and employees make

help shape these differences; that discretion exists to choose among options

and the processes used to implement them. This does not discount the

importance of environmental effects such as competitive pressures, changes

in tax laws and accounting conventions or workforce demographics. Indeed,

a strategic perspective implies the anticipation of such environmental

pressures and assesses whether these pressures require changes in pay

systems. But tracing all changes and variations in compensation systems

to inevitable exogenous imperatives, leaving only a minor role for

discretionary decision making, does not seem an accurate representation.

Perhaps most fundamental of all the tenets on which a strategic

perspective on compensation is based is the belief that fitting compensation

systems to environmental and organizational conditions makes a difference;

that systematic variation in compensation systems is more than random noise;

that making compensation policies and practices contingent on organizational

and environmental conditions has some desired effects on employee behaviors

and the performance of organizations. Considering that state of research

and theory in compensation, this is probably the greatest leap of faith

(Ehrenberg & Milkovich, 1987). In light of these beliefs, the present

review focuses on two basic issues: (1) what does it mean to be strategic

about compensation? and (2) what factors affect or are affected by

compensation strategies?
 4

WHAT DOES IT MEAN TO BE STRATEGIC?

The term strategy is often used to refer to everything considered

important. The danger is that if it refers to everything, it may mean

nothing. Generally, strategy refers to the overarching, long-term

directions of an organization that are critical to its survival and success.

Strategies take advantage of the opportunities and manage the threats in

the external environment by marshalling internal resources in some coherent,

consistent direction (Dyer, 1985). A strategy may be intended and formally

articulated in some plan or document, or it may emerge through the patterns

of decisions shown by the organization's behaviors. Thus, strategies are

both plans for the future and patterns from the past (Mintzberg, 1987).

Strategy applied to compensation management is particularly ill-

defined. Analogous to the more general definition just discussed, the

term connotes compensation decisions responsive to environmental

opportunities and threats, and linked to or supportive of the overall long-

term directions and purposes of the organization. Thus, all compensation

decisions are not strategic. Most probably are not. Deciding which job

evaluation plan to adopt and which merit increase grid to use are unlikely

candidates. Choosing whether to link pay increases to individual or team

performance and deciding the competitive position in the market are more

likely to have strategic consequences. Culling those decisions that are

not from those that are critical to the performance of the organization

is a major task in defining compensation strategies. Being strategic about

compensation implies support of the business strategy and sensitivity to

anticipated environmental pressures.

 5

But such a general characterization does not provide much leverage

for research or theory building. Nor does it offer much guidance for

managing compensation. And the folly of undertaking research based on

poorly defined constructs is well recognized (Schwab, 1980). Similarly,

basing managerial decisions on poorly thought out purposes is equally ill-

advised. without defining what is meant by strategic compensation

decisions, it will be difficult to examine the usefulness of such a

perspective.

As a place to start, I offer the following definition: a strategic

perspective on compensation focuses on the patterns of compensation

decisions that are critical to the performance of the organization. Such

decisions, in all likelihood, vary by employee groups within organizations.

The matrix shown as Figure 1 captures this definition. One dimension

involves the critical policy choices which taken together form a pattern

of decisions. The critical employee groups to which these patterns of

decisions apply is the other dimension.

--------------------------
Insert Figure 1 About Here
--------------------------

Given this definition, the major research tasks are to (1) identify

the compensation decisions and employee groups that are strategic, (2)

develop measures or descriptions of these decisions, (3) extract any basic

combination or patterns of decisions that may be related to a variety of

organizations and environmental conditions, and finally (4) determine if

compensation strategies affect workforce behaviors which, in turn, affect

the implementation of an organization strategy.

 6

strategic Employee Groups

The notion of compensation strategy originally surfaced in the

literature on executive compensation (Cooke, 1976, Ellig, 1981, Salter,

1973). From a strategic perspective, compensation for executives was

defined in terms of several basic elements: base pay, short- and long-

term incentives, benefits, and perquisites. The major strategic decisions

focused on the deployment of total compensation among the basic elements

to best achieve the missions of the organization. Long term incentives

as a percent of total compensation is an example. Attention was directed

at choices among various short-term versus long-term incentive schemes,

the relative emphasis on corporate versus subunit performance, and the

riskiness of the total compensation package.

More recently, a strategic perspective has been extended beyond

executives to middle managers (Kerr, 1985; Broderick, 1986), scientists

and engineers (Balkin & Gomez-Mejia, 1984) and finally to all employees

(Lawler, 1981; Carroll, 1987). An argument can be made that only executives

make strategic business decisions, hence only their compensation has

strategic implications. However, different employee groups may be critical

to the performance of different organizations. For example, one business

strategy may depend heavily on research and development, another on more

efficient production employees, and still another on the sales force.

If certain employee groups may be more (or less) critical to the success

of the organization than others, it follows that their reward systems become

an important part of implementing the organization's business strategy.

Little empirical work exists on identifying employee groups that are

strategically relevant. Lacking that, perhaps the best starting point

 7

is to simply use the basic occupations for which separate compensation

systems are designed. These typically include executives, managerial and

professional, scientists and engineers, sales, clerical and production.

strategic Compensation Decisions

Turning next to the other dimension of compensation strategy, the

patterns of critical decisions, Table 1 contains lists of decisions deemed

to be strategic in the literature. Both structure and process decisions

are included. The list proposed by Lawler (1981), while not the longest,is

perhaps the most inclusive. It includes the market position (level of

pay relative to competitors), internal versus external orientation,

hierarchy (the steepness of the pay structure and the basis--job versus

skills--for the pay structure reward mix, and the basis of rewards

(performance versus seniority, groups versus individual, criteria used,

etc.). Several issues listed by Carroll (1987) (performance measures,

size of bonus, timing, etc.) seem consistent with Lawler's more broadly

defined issues (e.g. basis for increases). The original issues proposed

for executive compensation have also become more broadly defined and applied

to all employees. For example, both issues proposed by Ellig, (1981) the

relative emphasis to be placed on the various elements of compensation,

and the short- versus long-term, are treated as part of the "mix" decision.

-------------------------
Insert Table 1 About Here
-------------------------

Salter (1973) and Lawler (1981) also considered a series of process

decisions to be strategic. These included congruency (consistency with

other organization systems), standardization of pay systems across subunits,

 8

communications (the type of data to disclose, the channels to use, etc.),

participation in decision making (levels of employees involved and nature

of involvement), and organization change strategy (the role of compensation

in organization change).

Kerr (1985), focusing on the compensation of general managers, offered

a somewhat different list (35 items in all), including the subjectivity

versus objectivity of performance criteria, the time orientation (short-

versus long-term), the values orientation (performance versus membership),

clarity of the performance-reward relationship, and the proportion of total

compensation devoted to incentives.

The expanding list of decisions claimed to be strategically relevant

raises doubts about the efficacy of a strategic perspective. It brings

to mind the multiple facets of job satisfaction and pay satisfaction that

made the constructs more complex than originally conceived (Heneman, 1985).

What is required is some research to separate those decisions that are

strategic from those that are not. At this point, adopting a generic list

of fundamental policy choices offers a framework for the present discussion

and perhaps a guide for future research. To this end, Table 2 contains

a list of six policies which I propose are strategically relevant. Each

policy involves several underlying decisions and options. These policies

were extracted from the compensation management literature and the work

discussed above.

-------------------------
Insert Table 2 About Here
f---------------
 9

Competitiveness

The first policy, the degree of competitiveness, can vary among

organizations and among occupations within organizations. From a strategic

perspective, competitiveness refers to positioning a firm's compensation

relative to its competitors (Belcher, 1987; Milkovich & Newman, 1987;

Carroll, 1987). Leading, meeting or following are the conventional options.

However, experience suggests that competitiveness is more complex (Milkovich

& Newman, 1987). The mix of pay forms, the risk-return tradeoffs in the

pay forms, and the average pay level relative to competitors are all

relevant aspects of a firm's policy regarding the competitiveness of its

compensation. The risk-return tradeoff can be illustrated by considering

two managerial pay schemes. One has a $50,000 base salary with merit,

the other a potential return of $70,000; that is, $40,000 base with a

$30,000 bonus potential. Whether these two competitive positions are

equivalent depends on the risk-return tradeoffs of prospect employees.

A risk-return tradeoff incorporates both the proportion of bonus to total

compensation and the likelihood of receiving the bonus (Rabin, 1987).

Clearly the two employers have adopted different competitive positions

in the market. The effects of these different positions on organization

performance and employee behavior are unknown. Such schemes are a common

feature of sales force pay systems (some are straight salary, others are

highly leveraged with incentives) and recent surveys suggest that it is

becoming more common in managerial pay (American Productivity Center, 1987).

 10

Internal structure

The nature of the internal pay structure is another fundamental policy

that is proposed to be strategically relevant. Typically it refers to

the distribution of rates, or internal pay differentials (Simon, 1957;

Mahoney, 1979; Ehrenberg & Milkovich, 1987). However, several choices

are involved. These include the number of levels in the pay hierarchy,

factors on which to base the hierarchy, the number of different systems

used to devise the structure, and its congruency with other organization

characteristics. Pay structures differ widely across organizations applying

different technologies. The premise underlying a strategic perspective

is that considerable discretion exists to design different pay hierarchies,

even in organizations with similar technologies. Some organizations have

few job classifications and wide ranges, obscuring differences in task

details and/or specific skill requirements. This allows flexibility to

deploy the workforce without requiring pay changes. other firms with

similar technologies adopt more job classifications with more detailed

specifications of work rules and skill requirements to provide a greater

sense of promotional opportunities (e.g., more title changes). In both

these cases the slope of the pay hierarchy is the same, but the number

of job classes and the differentials between classes differ.

The slopes of the hierarchies may also differ. Variations in

organizational design result from many factors and the internal pay

structure tends to mirror these arrangements. Further, the criteria on

which hierarchies are based may vary. Pay structures in some occupations

are consistent with employee attributes such as knowledge/skills and

experience (e.g., maturity curves for engineers and scientists or knowledge

 11

based pay for factory workers), and on job attributes for other occupations

(e.g., job evaluations for managerial, professional, and clerical work).

Finally, the issue of pay equity (i.e., comparable worth) is also

embedded in the internal pay structure. The decision to apply one or more

job evaluation plans across all occupations has implications for comparable

worth (Remick, 1984; Treiman & Hartman, 1981).

Forms of Pay

A third policy in the proposed strategic perspective pertains to the

forms of the mix of various elements of total compensation (Heneman &

Schwab, 1984; Heneman, 1986; Lawler, 1981; Salter, 1973). Total

compensation may include base pay, a variety of incentive schemes, cost

of living adjustments, various forms of stock options and an array of

benefits. Decisions include the number of forms to offer, the degree

to which each is contingent on employees' maintaining their membership

in the organization (e.g., entitlements) or performance (e.g., incentives),

the relative importance of each form (e.g., benefits as a percent of total

compensation) and the proportion of the workforce eligible for each form

For example, in some organizations all employees receive stock options

or deferred compensation, in others only a handful of executives are

covered.

Basis for Increases

The policies for granting pay increases are also proposed to be

strategic. Many facets to these policies are involved; they range from

an emphasis on short- versus long-term incentives (Carroll, 1987; Ellig,

 12

1976; Salter, 1973; Wallace, 1987), the degree of pay differentiation in

performance differences (Carroll, 1987), the size of the payments (Carroll,

1987; Krzystofiak, Newman & Krefting, 1982; Lawler, 1981), the relative

emphasis on individual versus subunit versus corporate performance (Carroll,

1987; Kerr, 1986; Lawler, 1981; Salter, 1973), and the emphasis on

guaranteed compensation (Carroll, 1987; Rabin, 1986).

Role in HR Strategy

Descriptions of firms' human resource strategies suggest that

compensation plays a variety of roles (Dyer, 1985). In some, compensation

plays a dominant role. High risk-high return incentive plans at financial

investment firms, and performance-based incentives at some manufacturing

firms are examples. In others, compensation appears to be in a coordinate

or even subordinate role to other human resource systems (Herzberg, 1959).

Instead, they may emphasize their employee relations policies (e.g. IBM's

employment security as a shared responsibility and the Hewlett Packard-

"HPWay" ) . In a similar vein, Lawler (1981) suggests that a compensation

system can be out on the point to signal changes in an organization business

strategy, or it can playa less prominent role during organization changes.

So the fifth policy proposed in a strategic perspective is the role of

compensation in the overall human resource strategy.

Administrative Style

Finally, the process used to administer compensation also is regarded

to have strategic properties (Broderick, 1985; Kerr, 1986; Lawler, 1981;

Salter, 1973). Administrative processes involve several choices. Among

 13

these are the nature of information to disclose to employees (i.e., broad

policies vs. specific details) the nature of employee participation in

pay design and administration, and the degree of centralization of pay

administration, the nature of dispute resolution procedures.

In summary, these six policies--competitive position, internal

structure, mix among forms, basis for increases, role in human resource

strategy and administrative style--represent a proposed definition of a

strategic perspective on compensation. The need to describe and measure

is a recurring theme in personnel research (Wallace, 1983). In the case

of compensation strategy, this means construct validation of patterns of

strategic decisions involved in the design and administration of pay.

Much work is required here, because the idea of being strategic about

compensation is new. Many employers are only beginning to consider what

it means and what issues are involved. However, research on an emerging

concept may afford an opportunity to offer some guidance in making relevant

compensation decisions, rather than studying past and often outdated issues.

One place to begin is to select employee groups most likely to be

critical to the implementation of an organization's business strategy;

more specifically, employees responsible for the organization's distinctive

competence (e.g., technology) and competitive advantage (e.g., marketing

strategy). General managers in highly decentralized firms and scientists,

engineers and marketing personnel in high technology firms are probably

examples. Once these strategically critical employee groups are identified,

then the patterns in the six compensation policies applied to them can

be assessed.
 14

Assessing Compensation strategies

strategy as applied to human resource management is bereft of research.

Most of the literature is prescriptive--case studies describing formal

procedures in specific employers. However, a few empirical studies are

beginning to emerge (deBejar & Milkovich, 1986; Dyer, 1985). studies of

strategies specifically related to compensation are even rarer. This

section examines them.

Only one reported study directly posed the question, "Can a set of

critical organizational-level pay decision (i.e., strategic decisions)

be identified and measured?" In this study, (Broderick, 1985), five basic

strategic decisions (competitiveness, hierarchy, mix, increase basis and

administrative style) were extracted from the literature. Two hundred

and eight corporate compensation directors answered a 70-item questionnaire

based on the five basic decisions. Compensation for middle managers was

the focus of the study. Seven factors, shown in Table 3, emerged from

the factor analysis and confirmed most of the strategic decisions speculated

about in the literature. Three structural factors emerged: (1), external

competitiveness (expressed as leads, meets or follows competitors' average

pay level); (2), mix (expressed as the proportion of total compensation

contingent on membership or performance); and (3), basis for pay increases

(expressed as increases based on efficiency/costs improvement or revenue

growth) . And four aspects of administrative style also emerged: (1),

employee participation (2), level of managers approving pay decisions (3)

similarity of plans across business units and (4), formalization. Items

related to the internal pay hierarchies were not found to be significant,

and items about the role of compensation in the overall human resource
 15

strategy were not included.

-------------------------
Insert Table 3 About Here
-------------------------

It is not clear why the hierarchical factor was not confirmed. It

may very well be that decisions about the nature of internal pay structures

are infrequently made; that only major environmental jolts, such as threats

of unionization, lawsuits, economic survival or major technological

innovations, act as triggers to cause employers to reconsider the factors

on which the internal structure is based. It may also be that managers

do not consider policies regarding internal structure to be strategic.

It would be interesting to see if replicating this study on another employee

group--engineers, for example--would yield similar results.

All of the remaining research surveyed in this paper adopted a

particular set of pay decisions assumed by the researchers to be strategic.

Little concern over the correctness of their assumption is reported.

Nevertheless, the decisions deemed to be strategic in the literature found

some empirical support in Broderick's (1985) study, at least for managerial

compensation.

FACTORS AFFECTING STRATEGIC CHOICES IN COMPENSATION

The basic issue here is to determine what factors shape the patterns

of policy choices in compensation. Preliminary research in overall human

resource strategy and compensation suggests the following three major sets

of factors are involved: organization business strategies, and factors

in the internal and external environment.

 16

--------------------------
Insert Figure 2 About Here
--------------------------

Using the schematic in Figure 2 as a guide, studies of the determinants

of compensation strategy can be grouped into these three sets. Those that

focused primarily on the relationship of organization strategies (i.e.,

corporate, business unit, and functional human resource strategies) to

compensation policies and systems is the first. Most of the reported

research falls here, since in the literature, compensation strategy is

opined to be primarily a function of the organization's overall strategy.

The second group consists of a few studies which consider factors making

up the organization's internal environment. These variables include its

structural arrangements, its administrative style, and its technological

characteristics. Finally, the schematic in Figure 2 suggest the possibility

of a third set of studies; those that treat factors in the external

environment as important determinants of compensation policies.

Organization strategy and Compensation strategy

The nature of an organization's strategy has been postulated to be

the primary determinant of its compensation strategy (Balkin & Gomez-Mejia,

1984; Lawler, 1981; Salter 1973). A convention in the organization

literature is to distinguish among three levels of strategies: corporate,

business unit, functional. These are seen as interrelated but distinct

concepts (Hofer & Schendel, 1978; Galbraith & Schendel, 1983; Leontiades,

1982). These three levels have been carried into the strategic human

resource management literature (Dyer, 1985). Since such a variety of

definitions, typologies, and measures of strategies exists at each level,

 17

only those used in research directly related to compensation are discussed

here.

Corporate strategies

The two proxies for corporate strategy employed in the research on

compensation strategy are diversification and life cycles. Neither of

these proxies are direct measures of organization strategy. Diversification

seems to be an outcome of a corporate strategy which involves operating

in multiple product markets. Life cycles, arguably, could be a

determination of an organization's business strategy. The lack of clarity

in the meaning of these proxies is but one of the limitation inherent in

this research. Diversification is the most widely used. With it,

organizations are classified as to whether they exhibit a single, dominant,

related, or unrelated product diversification strategy (Rumelt, 1974).

According to organization theory, greater diversification gives rise to

the need for mechanisms to integrate and control the corporation's separate

business units consistent with corporate objectives (Lawrence & Lorsch,

1967). The compensation system serves as a key integration and control

mechanism available to management.

Several studies of corporate diversification also examined compensation

issues (Kerr, 1985). Three issues were of principal interest: (1) to what

degree were division general managers' incentives based on business unit

versus some combination of business unit and corporate performance; (2)

to what degree were their performance measures subjective versus

quantitative and based on end results; and (3) to what degree were general

managers' bonuses discretionary versus formula-based.

 18

One study of five conglomerates (i.e., unrelated product firms that

grew rapidly by acquisition) and five diversified firms (i.e., related

products that grew more slowly by internal expansion) reported that the

basis for pay increases (performance measurement) and incentives (pay mix)

for division managers varied. This difference was attributed to different

corporate/division relationships in the conglomerates (Berg, 1969, 1973).

The conglomerate's goals were to retain the division managers of acquired

firms and to motivate them to operate as autonomous entrepreneurs

accountable for the performance of their divisions. Accordingly,

compensation increases were based on division performance, using

quantitative end results or financial measures, with considerable discretion

in establishing amounts of bonus awards. Management was by incentives

rather than by controls.

Lorsch and Allen (1973) studied two conglomerates and one vertically

integrated firm. The conglomerates used more formalized procedures with

predetermined indices based on division results; managers' pay increases

were tied to objective formulas and the conglomerates used financial end

results criteria. The integrated firm used a less formal system based

on corporate results, incorporating some intermediate measures as well

as end results measures, which were not linked to pay increases by a

formula. Pitts (1974, 1976) studied the evaluation of division managers

in six Ifinternal growth diversified firmslf (IGDs), similar to Berg's

conglomerates, and five "acquisitive growth diversified firmslf (AGDs),

similar to Berg's diversified majors. He found that four of the AGDs had

pay increases based on division results only; the IGDs used some combination

of division, group, and corporate results. Four AGDs computed bonus awards
 19

using a formula-based process on quantitative, financial type performance

measures that allowed no discretion in determining bonuses. The rest of

the firms allowed for varying degree of discretion in bonus determination.

These studies, though consistent in findings, only examined a limited

range of the compensation policies proposed earlier in this paper, and

focused only on business unit level managers. Due to sample size

limitations, factors such as size, ratio of labor costs to total costs,

profitability, and so on, were not controlled. Considering these

limitations, Kerr (1985) designed a study of 20 firms, controlling the

sample for size (revenues). Compensation policies included in this study

were pay increase criteria, performance measurement, mix (i.e., salary,

bonus, stock awards, perquisites, and promotions) and administrative

processes. Corporate strategy was measured on two dimensions: degree

of diversification (single-product, dominant-product, related-product or

unrelated product); and process of diversification (growth through internal

evolution versus expansion through mergers, acquisitions, and joint

ventures). Kerr categorized firms according to similarity of compensation

patterns, analogous to the definition of compensation strategy proposed

above. Two compensation strategies were identified. In one, labelled

hierarchy-based, the bonuses for general managers were subjectively

determined and constituted a small portion of total compensation. In the

other, labelled a formal performance based strategy, precise definitions

of performance were tightly linked to pay increases. The process was formal

and objective, the general managers' bonuses were large and formula-based,

allowing little discretion. Internal diversifiers followed the hierarchical

based pay strategy and the evolutionary firms, followed the formal
 20

performance-based strategy. Kerr concluded that compensation strategy

was influenced more by the process of diversification than by the extent

of diversification and that the corporate strategy influenced pay strategy

through generating a need for control over the business units.

Based on these studies, the following propositions emerge as

corporations become increasingly diversified: (1) quantitative measures

are used to evaluate managerial performance, (2) pay increases are

determined by objective formulas, (3) performance is more likely to be

defined through subunit performance rather than corporate results, and

(4) compensation strategies are affected by the process of diversification

(internal vs. acquisition).

However, a recent study examining the relationship among corporate

diversification, pay increase criteria, and corporate manager compensation

did not support these earlier findings (Napier & Smith, 1985). Less

diversified firms were reported to use more objective pay increase criteria

and bonuses were a significantly greater proportion of total compensation

in more diversified corporations. The differences in results may be due

to the small sample sizes and the differences in employee groups studied.

The earlier studies all focused on business unit general managers, whereas

Napier and Smith examined pay strategies for a more heterogeneous group,

"corporate level managers." Once again, these differences point to the

need for rigorous definitions of employee groups as well as organization

charact~ristics since strategic compensation decisions are conceived to

be related to both.
 21

Life Cycles

Perhaps the most detailed prescriptions of how compensation strategy

should vary with organization strategy have used the concept of life cycle.

The application of life cycles in compensation management originated in

executive compensation, but has since been extended to cover all employees'

pay (Cook, 1973; Ellig, 1982; Milkovich, 1986).

Prescriptions vary depending on the author, but generally the

recommended strategy for an organization in the startup phase includes

an external market emphasis, low base/high incentive mix (though

disagreement exists on the relative emphasis to place on long- versus short-

term incentives), low benefits, and an administrative style that emphasizes

decentralization and informality. The recommended strategy for

mature/stable firms typically has the following pattern: internal equity

emphasis, competitiveness that meets/leads competition, a high base and

benefits/low incentives mix, and administrative processes consistent with

control.

Life cycles have received widespread attention as heuristic devices

in the professional compensation literature, yet, the concept has been

widely criticized. These criticisms include: more than one set of

compensation policies may be appropriate for a given cycle (Wils & Dyer,

1984; Milkovich, 1986; Milkovich & Newman, 1987), it is deterministic (e.g.,

managers' objectives may be to avoid or prevent declining cycles) (Kerr,

1985); and organizations typically have multiple products at different

stages in a life cycle, making classification difficult. Confusion also

exists over types of cycles. Some use product life cycle (Ellig, 1981),

whereas others use the market or industry life cycle and the company life
 22

cycle (Cooke, 1973). Cooke even alludes to the life cycle or aging of

compensation techniques, paralleling the life cycle of the firm. Life

cycles may more accurately reflect business unit rather than corporate

characteristics, but the criticisms still apply.

For all its attention as a heuristic device, research on life cycles

and compensation systems is rare. As part of their study of 33 high tech

and 72 non-high tech firms' compensation strategies, Balkin and Gomez-Mejia

(1984) reported the effects of two stages in the life cycle; growth (defined

as annual sales growth of 10% or greater) and mature (defined in terms

of product fmniliarity). Firms were classified as high tech if the ratio

of their R&D costs to total revenues exceeded 5%. The hypothesis was that

higher tech firms in the growth stage are more likely to follow an

incentive-based strategy than companies at the mature stage. The authors

concluded that mature firms are more likely to adopt incentives and select

a lower competitive position than firms in the growth stage, which is just

the reverse of what was expected. For some reason the product life cycle

was not significantly related to compensation strategies in firms that

placed less emphasis on R&D. Caution needs to be exercised here. For

example, product familiarity may be more of an indicator of market

penetration and saturation than are measure of a mature stage.

In another study, in which 2000 manufacturing firms were classified

into growth, mature, or declining stages, Anderson and Zeithaml (1984)

reported that the firms' competitiveness (pay level relative to competitors)

was greater in each progressive stage. They also reported that the higher

relative pay in mature firms adversely affected their return on investment.

However, growth firms with higher pay levels relative to competitors'

 23
reported increased market share.

Business Unit Strategies

In perhaps the most ambitious study of compensation strategy, Gomez-

Mejia (1987) examined the relationship of both corporate and business unit

strategies to pay strategies. The study was based on survey responses

from compensation professionals in 192 business units in manufacturing

firms. Corporate strategy was defined as the extent of product market

diversification, using Rumelt's classification scheme. Business unit

strategies were grouped into two types: growth and maintenance.

Compensation strategies had several dimensions: competitiveness (i.e.,

market positioning of pay level), pay mix (i.e., relative importance of

salary, benefits and incentives), and 13 administrative policy choices,

which included the basis for pay increases and procedures. The employee

groups to which these compensation strategies applied were not specified.

A number of control variables were also included specifically sales volume,

profitability, and ratio of labor costs to total costs.

The preliminary findings show that the most diversified corporations

(related product markets in this study) are associated with higher pay

levels (competitiveness), greater emphasis on salaries and benefits than

incentives (mix), greater formalization, centralization, and a higher degree

of secrecy. The least diversified firms were associated with lower

competitiveness and greater emphasis on incentives in their pay mix, more

open communication, and decentralized decision making. Using discriminant

analysis, the patterns of compensation policies were able to correctly

classify business units into their appropriate strategy considerably beyond

 24

chance. The results are interpreted as supporting the proposition that

management adjusts its pay strategies to fit the organization's strategies

(Gomez-Mejia, 1987). In a given business unit, compensation policies and

techniques are affected by both the degree of decentralization at the

corporate level and whether the business unit faces growth or maintenance

in its product markets. And the identifiable patterns of compensation

policies can be identified for different types of business unit strategies.

Harking back to the schematic in Figure 2, the research suggests that

a corporate business strategy has both direct effects on a business unit's

approach to compensation and an indirect effect through the various business

unit strategies. More specifically, the extent that a corporation

diversifies its products, and the process it uses to achieve this

diversification, directly affect its degree of competitiveness, emphasis

on incentives, basis used to determine pay increases, and administrative

style. Conflicting evidence exists on the nature of the relationship.

The strategy of each business unit, defined in terms of its market niche,

also plays a direct role in shaping compensation strategies.

Caution regarding the robustness of these findings needs to be

exercised. Every article emphasizes its preliminary nature; the employee

groups to which the pay policies apply tend to be managerial or professional

or are not well specified; the findings are based on surveyor interview

data; and the data tend to be the perceptions of personnel/compensation

managers.
 25

Human Resource strategy

Two studies report findings that suggest that an organization's human

resource strategy also affects its compensation policies. The first

examined the relationship between twenty-two business units' strategies

and dimensions of their human resource strategies (Wils & Dyer, 1984).

The business unit strategies were classified as growth, profit, or

stabilization. Human resource strategies were found to vary among these

three business strategies. Managers of growth units listed compensation,

recruitment of new managers, and organization development as the most

important personnel activities. Compensation was not seen as among the

most important activities in either profit or stabilized units. This study

is unique in that it surveyed line managers perceptions rather than

personnel specialists. The authors concluded that compensation in the

context of the total human resource strategy varied with the business

strategies an organization pursues.

The second study analyzed the business and human resource strategies

of business units (129) from a variety of industries to derive an empirical

definition of human resource strategy (deBejar & Milkovich, 1986). After

factor analyzing items describing major personnel activities, the nature

of incentive compensation emerged as a critical dimension. other dimensions

of compensation strategy failed to emerge as critical aspects of a human

resource strategy.

These two studies suggest that an organization's approach to

compensation is also related to its overall human resource strategy. The

results are very preliminary. Compensation was important in growth firms'

human resource strategy but not in other types of business strategy, and
 26

incentives may be more closely related to the human resource strategy than

other forms of compensation. Here again, managerial compensation was the

focus of these studies.

Internal Environment and Compensation strategy

Obviously, other organization characteristics besides strategies affect

differences in compensation systems. These are treated as part of the

nature of the internal organization environment in Figure 3. The variables

listed are those used in studies reviewed here. Many of them were treated

as control variables (e.g. size, profitability, labor costs/total costs).

Miles and Snow (1978) proposed an approach to typing the

characteristics of organizations which incorporated elements of strategy,

but went beyond it to include structure, administrative style and the like.

The three organization prototypes, Defenders, Prospectors and Analyzers,

have been related to compensation strategies (Broderick, 1985; Carroll,

1987). Defenders and Prospectors have very different, almost opposite

characteristics, whereas Analyzers are a composite of the other two. A

Defender operates in narrowly defined, stable markets. Its structural

design is functional, it emphasizes cost/efficiency-based approaches, and

its administrative style tends to be centralized, formal, and standardized.

Prospectors, by contrast, emphasize innovative approaches to dynamic,

changing markets. Its structure tends to be divisional or product-based,

and its administrative style tends to be decentralized, informal, and

flexible. Analyzers are in multiple markets and tend to be a mixture of

the characteristics of the other two.

 27

Carroll (1987) has suggested that organizations with such different

characteristics are likely to adopt different compensation strategies.

Broderick (1985) found that they do. The results of her study are

summarized in Table 3. Controlling for organization size (i.e., net sales

and number of employees) and industry, she reported that the patterns among

seven policies (see the third column in Table 3) for middle manager pay

systems differed significantly between Defender and Prospector

organizations. When considered individually, three of the seven policies-

-basis for pay increases (efficiency versus growth), participation, and

formalization--varied significantly across organization types. The other

individual dimensions varied in the expected directions, but were not

significant. Using discriminant analysis, the patterns among the seven

dimensions were able to correctly classify the organizations as the correct

type significantly beyond chance, thus offering additional evidence

supporting the proposition that patterns of compensation decisions vary

among different types of organizations.

Internal labor markets is another approach to classify organization

environments (Osterman, 1984; Doeringer & Piore, 1971). Defined in terms

of the rules that regulate the allocation and compensation of human

resources, internal labor markets have been variously classified as open

(hiring at all levels) versus closed (hiring only at lower skill levels),

craft-professional (technically skilled with little intra-organizational

mobility except within the craft or profession), and salaried-managerial

(general skills with high cross-functional mobility). Different types

of internal markets are described as possessing different compensation

policies. A few case descriptions of internal markets have been published,

 28

but they remain to be content analyzed for differences in compensation

policies and practices (Osterman, 1984). The nature of the rules used

to determine pay are so intertwined with the definition of internal markets

that an independent measure of each type of market may prove difficult.

External Environment and Compensation strategy

The model in Figure 2 contains a third vector of variables:

legislation, union, and labor markets. This is the external environment

which directly affects compensation strategies. None of the research

studies cited above considered the effects of environmental differences.

Some attempted to control for these effects through sample selection (Balkin

& Gomez-Mejia, 1984; Broderick, 1985; Gomez-Mejia, 1987; Kerr, 1985), but

most simply do not refer to the possibility of environmental effects.

The effect of unions on various aspects of compensation strategy

(level, mix, hierarchy, basis for increases, administrative procedures)

has a substantial research base (Medoff & Freeman, 1984). This body of

knowledge is beginning to be integrated into the strategic human resource

management models (Kochan, Katz & McKersie, 1986; Osterman, 1988).

The responsiveness of compensation decisions to legislative change

is widely discussed, but not systematically researched. For example, the

1986 Tax Reform Act is said to be having a significant effect on executive

and middle management compensation (Cooke, 1987). Other examples of

significant legislation are pension reform and Minnesota's comparable worth

law. Legislative change may trigger different responses in compensation

policies for certain employee groups. For example, include changes in

minimum wage affects lower paid employees, tax reform affects executive
 29
pay, and pension reform affects all covered employees.

Whether legislative changes allow managers sufficient discretion to

adopt different policies based on their business strategy is open to

conjecture. Increases in the legally required minimum wage need to be

paid. There is nothing too strategic about that decision. However, the

decision to increase investment in automation in anticipation of increased

labor costs has strategic properties since it is critical to the

implementation of the organization strategy. Non-legislative external

jolts such as a strike do permit a variety of adaptations by organizations

with different business strategies and different internal environments.

In summary, external factors have a major effect on the strategic

choices made in compensation. The effects of unions and broad industry

characteristics are well documented in the industrial relations and labor

economics literature. What is missing is systematic data on whether

organizations faced with similar industry and other external pressures

adopt different patterns of compensation policies and practices.

DO COMPENSATION STRATEGIES MATTER

Here we face the "so what" question: to what extent do compensation

strategies matter? Most of those seeking an answer to this question rely

upon contingency theory and the related concept of "fit." Contingency

theory seems a situational art form, ... "there is no one best way--but

all ways...are not equally effective. The choice is dependent or contingent

on something" (Galbraith & Nathanson, 1979). Contingency theory applied

to compensation strategy is depicted in Figure 3. The basic premise is

that compensation strategies and organization strategies should "fit" each

 30

other; the better the fit, the better the organization's performance.

--------------------------
Insert Figure 3 About Here
--------------------------

Conceptually, several contingencies between organization and

compensation strategies are implied in this model. The most obvious one

is that compensation strategies are more likely to be effective if they

are contingent on the overall strategy followed by an organization, other

things being equal (e.g., the internal and external environment).

Conversely and less apparently an organization's business strategy is more

likely to be effective if it is contingent on it's compensation strategy.

This contingency rests on the premise that successful implementation of

business strategies depends on human resources. Formulating an

organization's strategy involves assessing internal resources. Compensation

decisions directly affect these resources through their impact on expenses

and on their ability to attract, retain, and motivate critical human

resources.

To the extent that the current pay systems are inflexible, they act

as a constraint on the organization's ability to shift its strategy. At

the minimum, implementing a new compensation strategy which better fits

the organization's strategy may be hindered by the existence of the original

pay system, existing union contracts, and the internal norms and

expectations. In such cases, contingency theory predicts that performance

suffers.

The degree of fit between compensation strategy and organization

strategy contributes to organization performance by signaling and rewarding

the behaviors that are consistent with the organization's objectives.

 31

Further, better fit more accurately signals to applicants the types of

behaviors expected and accommodates compensation demands on the

organization's cash flow (Ellig, 1983). So the degree of fit is the

cornerstone of contingency theory and underlies the presumed effect that

compensation strategy has an organization performance.

Yet doubts remain; one gets a queasy sense of constructing on shifting

sands. All three constructs on which performance depends--organization

strategy, compensation strategy and fit--are elusive, especially fit.

This applies to its use in the policy/strategy literature as well as in

compensation management (Van de Ven & Drazin, 1985; Venkatraman & Gran,

1986). Broderick (1985) defined fit empirically as the variance between

compensation policies and business strategies. Two measures were employed.

One was the relationship of each dimension of compensation strategy with

differences in corporate strategy. The other was the relationships between

different patterns of compensation policies and differences in

organizational strategies.

Contingency models applied to compensation treat fit as static. The

reality may be that matching compensation and organization strategies is

like shooting at a moving target. This suggests that both timing and degree

of fit affect performance. A firm that fits its pay system to support

its business strategy, and does it quickly, may have a competitive

advantage. For example, the move to a greater emphasis on performance,

to define performance as team or unit (gainsharing), rather than individual,

and to knowledge-based pay hierarchies is believed to create a competitive

advantage (Lawler, 1981).

 32

Just how does one determine the appropriate degree of fit. On the

one hand, the more congruent the compensation system with the organization

and its environment, the better the performance. On the other hand,

tailoring compensation strategies to fit too tightly, may straightjacket

the flexibility required to take advantage of future opportunities (Mahoney,

1987).

Research on compensation strategy is so recent that little work has

been reported on its effects on organization performance or employee

behaviors. Some of the work on executive compensation and firm performance

is related (Ehrenberg & Milkovich, 1987). Two studies included attempts

to directly examine the relationship among organization strategy,

compensation strategy and performance (Balkin & Gomez-Mejia 1987, Gomez-

Mejia, 1987). Performance was assessed by asking compensation directors

the extent to which the pay system contributed to the achievement of

organizational goals. The limitations of this measure were recognized

by the researchers but justified using the logic that acceptability is

a key criterion of compensation system performance. Even if this logic

is accepted, managers and employees are arguably more appropriate

constituents to judge pay system acceptability (Tsui & Milkovich, 1987).

So the effects of compensation strategy and the degree of its fit with

organization strategy on performance remain unplowed turf. Considering

the elusiveness of the notion of the degree of fit, it seems like risky

research.
 33

CONCLUDING OBSERVATIONS

Research on compensation strategy began in the context of executive

compensation and in studies of the relationships between business strategy,

structure, and process. Compensation was conceived as a control mechanism,

executives were the focal group and the nature of pay incentive schemes

was the principal dimension of compensation included. Little recognition

was given to the need to define compensation more systematically.

Typically, the level of analysis was the corporation, and strategies studied

involved diversification.

In subsequent studies, the definition of compensation, the variables

included and the methodologies evolved in several ways. The definition

of compensation needs to be broadened to recognize its multidimensionality.

Research has begun to study variations in the total pattern of compensation

policies in addition to variations in specific policies. The focal group

has been extended beyond executives, to all employees and to employee groups

that are critical to the organization's success. The determinants that

may affect compensation strategy have extended beyond corporate strategies

to include business unit strategies, internal organization factors, and

external factors. Thus, control variables such as industry, labor

costs/total costs, profitability, sales, workforce size, and the like need

to be included in research designs.

More attention needs to be devoted to the effect of environmental

jolts on compensation strategies. It may be, as Mintzberg (1987) suggests,

that strategic reorientations occur in brief quantum leaps. Accordingly,

major jolts are required before organizations realign their business

strategies to set their direction or layout new courses of action. In

 34

between such reorientations, stability prevails. If this is so, then

studies of organizations experiencing such jolts and reorientations may

shed light on which compensation decisions have strategic properties,

and what their effects are likely to be. Finally, studies of the

relationship between compensation strategy and organization performance

are beginning, but more are required.

At the root of the interest in a strategic perspective of compensation

is the basic tenet referred to at the beginning of this paper: that human

resource policies in general, and compensation policies in particular,

affect workforce and organization performance. The belief is largely

untested, yet the entire field of human resource management rests upon

it. The research agenda that emerges from a desire to examine this tenet

is extremely complex (Dyer, 1980). It is part of the organizational

perspective on human resource management alluded to at the beginning of

this paper. Its conceptual links are as much to policy, microeconomics,

finance, organization theory and sociology as to micro organization behavior

and psychology (Dyer, 1985).

An immediate need exists for research aimed at collecting accurate

descriptions of the content of compensation strategy and the process

involved in its formulation. What are the critical dimensions of

compensation? For which employee groups? How should such questions be

answered? Asking and/or observing those who are in strategically relevant

roles, such as executives and members of corporate compensation committees,

is one approach. Another is to undertake "policy capturing" studies.

Both require access and data that simply are not readily available.
 35

Beyond descriptive research, more work is needed to understand both

what determines variations in patterns of compensation decisions their

effects. A major challenge is to formulate manageable research issues.

Issues too narrowly defined suffer from ignoring the multi- dimensionality

of compensation and the context in which compensation decisions occur.

On the other hand, issues too broadly drawn are too time consuming, too

ambiguous, too expensive, and often poorly specified.

Perhaps a place to begin is to identify compensation decisions that

have strategic properties. For example, do firms within the same industry

establish different competitive positions in labor markets? Conventional

wisdom is that they do. How do they accomplish this--by different average

levels of base pay, by varying the risk-return tradeoffs or the ratio of

incentives to total compensation? Do characteristics of organizations

vary with their competitive position? These might include some of the

determinants discussed in this paper such as organization strategies,

organization characteristics, and external factors. Finally does a firm's

competitive position have any discernable effect on the size and quality

of the applicant pool, on its ability to hire those people it selects,

or its ability to retain high performers?

Similar studies need to be conducted for each aspect of compensation.

For example, little is known about the nature of the pay structure or the

mix of pay forms and their effects on workforce behaviors. The same can

be said about each of the dimensions of compensation.

In closing, it is useful to step back and consider the nature of

compensation management. A fairly convincing argument can be made that

existing compensation policies and practices have grown over time in a

 36

somewhat haphazard manner, as ad hoc administrative responses to various

pressure, rather than through some rational, analytical, objective-directed

process. If that is so, then much of the foregoing has simply been an

attempt to impose structure and rationality on compensation management.

But even if this is the case, the need remains to understand the variation

in these decisions made by organizations and how these variations affect

the behaviors of the workforce and the success of the organization.

 37

ACKNOWLEDGEMENTS

(1) Many people have contributed to the thoughts that are in this paper.

Among the most prominent are three of my former graduate students,

Renae Broderick, Gloria deBejar and Jeanne Adkins. Several colleagues

offered valuable comments, I am particularly grateful to Sara Rynes,

Vida Scarpello, Lee Dyer and Jerry Newman.

 38

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 T3b1e 1
Evolution of Compensation Decisions Considered Critical to Organiz~tion Performance

E11ig/Cooke (1976) Salter (1973) Lawler (1981) Carroll (1987)

Employee Executives and

Occupation Executives Managers All Employees All Employees

Structure Relative Emphasis Short vs. long term Market position Pay level in market
(Design) on each element incentives Internal vs. ex- Internal equity
Short vs. long term Unit vs. corporate ternal emphasis Performance Measures
incentives performance Degree of hierarchy Frequency of Measures
Degree of risk Reward mix Size of Bonus
(bonus/base) Basis for increases Merit Differentiation
Use of Individual
Bonus
Use of Group Bonus
Long vs. Short Term
use
Deferred Compensation
Use of Gainsharing
Use of Guaranteed
Compensation

Process Pay system congru- Pay system congru-

(Adminis- ency ency
trative Standardization Decision making
style) across subunits Centralization
Communications
Change strategy

.p..
f-J
 43
Table 2

STRATEGICALLY RELEVANT COMPENSATION POLICIES: AN A PRIORI SET

1) COMPETITIVENESS - Competitive position relative to competi-

tion

- Lead, lag, meet

- Total compensation, risk-return trade-off

2) INTERNAL STRUCTURE - Internal pay differentials

- Number of levels, criteria for hierarchy,

congruency with organization features

- Number of different job evaluation systems

used

3) MIX AMONG FORMS - Forms to offer

- Relative importance of each

- Short vs. long term

4) BASIS FOR INCREASES - Membership vs. performance

- Specific criteria, individual, unit,

corporate performance

- Size and frequency

5) ROLE IN OVERALL HUMAN - Dominant vs. coordinate vs. subordinate

RESOURCES STRATEGY
- Signal vs. support organization change

6) ADMINISTRATIVE STYLE - Employee participation

- Communications

- Centralization

- Dispute resolution mechanisms

 Table.3

Empirically Derived Dimensions of Compensation Str~tegy

Strategic Issues Liter~ture. Bascd Dimensions Empirically Based Dimensions

(1) Competitiveness (1) External Competition vs. (1) External Competitiveness

Internal Pressures

(2) Internal Hierarchics (2) Differential Hierarchies vs.

Egalitarian Arrangements

Job Content vs.

Knowledge Requirements

(3) Mix (3) Membership vs. Performance (2) Performance/Membership

(4) Pay Increase Bases (4) Corporate, subunit vs. (3) Efficiency (costs) vs.
Individual Growth

Short vs. Long Term

(5) Administrative Style (5) Degree of Employee Participa- (4) Level of managers par-
tion ticipating

Degree of Centralization (5) Level of managers ap-

proving decisions

Degree of Standardization (6) Standardization, simi-

(consistency across subunits)
larity of plans across

Degree of Formalization . units

(1) Formalization
written documentation

Based on Broderick (1985).

+:--
~
 45

Figure 1

A STRATEGIC PERSPECTIVE ON COMPENSATION

CRITICAL EMPLOYEES GROUPS

Executives R&D Sales Production . . . . .

CRITICAL
Compensation Strategies:

POLICY Patterns of Compensation Decisions

that are Critical to the Performance

CHOICES
of the Organization
 Figure 2

DETERMINANTS OF COMPENSATION STRATEGY

Internal
Environment
.Organization Types
.Internal Labor Markets
) .Size (
.Profitability
.Labor Costs/
Total Costs

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~
 .. ..

Figure 3

Contingency Model Applied to Compensation Strategy

Organization Compensation
Strategies Strategies

Organization
Performance and.
Workforce Behaviors

.p..
J